CH 7 from ECON Slides

Businesses and the Costs of Production

Understanding the complexities involved in starting a business, including determining costs associated with production, is essential for the success of any new venture. This involves not only assessing the finances but also being keenly aware of various factors influencing startup costs and long-term sustainability.

Initial Steps

• Consider the question: "How do YOU eat an elephant?!" This metaphorical question highlights the significance of breaking down the process into manageable parts. Starting a business may seem overwhelming, but tackling each component step-by-step is crucial.

• Assess Initial Business Considerations and Expenditures Needed to Begin. Identify your core product or service, target market, and competition to better understand what initial investments will be necessary.

• Estimate All Expenditures Required to Produce the Product. This includes everything from raw materials to marketing expenses.

• Add up Expenditures to Determine Total Costs. Knowing the total cost will help in pricing strategies and financial planning. An example can be illustrated with Grattan’s Clown Town USA, which might require a detailed cost assessment due to its unique operating model.

Key Expenditures to Consider

While starting a business, various costs often escape the entrepreneur's attention. Key expenditures include:

• Product Inventory: Essential for supply and fulfilling customer demands.

• Transportation Costs: Logistics and delivery of goods can significantly affect overall expenditure.

• Attorney Fees: Legal costs for setting up a business structure and ensuring compliance with regulations.

• Opportunity Costs: The potential gain missed when choosing one option over another.

• Computers and Office Supplies: Needed for daily operations and administration.

• Phone Lines: Communication tools vital for customer service and internal coordination.

• Furniture (Chairs, Desks): Necessary for creating a functional workspace.

• Advertising Expenses: Crucial for marketing your business and reaching target audiences.

• Worker Salaries and Benefits: The biggest ongoing expense for most businesses.

• Packaging: Important for product presentation and quality perception.

• Internet Access: Required for online operations and communications.

• Payroll Taxes: A significant component of labor costs.

• Copyrights and Patents: Protecting intellectual property may involve additional costs.

• Rent: Regular payments for physical space can dramatically affect cash flow.

• Filing Cabinets: Essential for organization and record-keeping. Overall possible costs can reach millions of dollars, requiring comprehensive planning and funding.

Understanding Profit

Differentiating between accounting profit and economic profit is vital for assessing a business’s financial health:

• Accounting Profit: Calculated as Revenue - Total Costs. This reflects the straightforward financial outcome.

• Economic Profit: Defined as Total Revenue - Total Opportunity Costs, which provides insight beyond simple accounting measures.

• Total Opportunity Costs = Explicit Costs + Implicit Costs: Recognizing what is given up in choosing one option over another is essential for making informed decisions.

Costs of Production

Understanding what constitutes the costs involved in production includes:

• Total Costs: Encompass everything given up to produce goods, typically measured in monetary terms.

• Explicit Costs: Direct payments made to non-owners for inputs like raw materials, labor, and utilities.

• Implicit Costs: Opportunity costs associated with the firm’s own resources, such as the owner's time and investment in the company rather than work elsewhere.

Economic Profit and Costs

Understanding the relationship between various costs:

• Distinction between explicit costs (actual cash outflows) and accounting profits (net income) is necessary for evaluating business viability.

• Importance of implicit costs in evaluating overall economic profit can lead to more informed strategic decisions.

Production Function

• Inputs (labor, materials) are transformed into outputs (finished goods).

• Focus on the relationship between input quantity and output quantity assumes fixed technology.

Short Run vs Long Run

• Short Run: Some inputs are variable while others remain fixed (e.g., factory size). Businesses must strategize under these constraints.

• Long Run: All inputs can vary; firms can enter or exit the market freely, allowing for adjustments based on market conditions.

Production Relationships

Key concepts involved:

• Total Product (TP): Total quantity produced refers to the overall output achieved.

• Marginal Product (MP): Changes in total product resulting from adding an additional unit of labor or input; crucial for evaluating worker productivity.

• Average Product (AP): Total product divided by the amount of labor used, providing insight into efficiency.

Rationale Thinking

• Emphasizes the importance of marginal thinking in decision-making processes, urging businesses to consider the incremental benefits of additional inputs.

Diminishing Marginal Returns

Reasons for diminishing returns include:

• Resources remain fixed; in a production scenario, adding more workers can lead to a decrease in the marginal product after a certain point.

• Practical Example: Making Hamburgers: Discussing the optimal number of workers for efficiency in burger production and how productivity varies with additional labor.

Law of Diminishing Returns

Applies when:

• Resources of equal quality are used in production.

• Technology remains constant; therefore, at some stage, the addition of variable resources leads to falling marginal product.

Costs in the Short Run

• Fixed Costs (TFC): Costs that remain unchanged regardless of output levels, such as rent and machinery purchases.

• Variable Costs (TVC): Costs that fluctuate with production levels, like raw materials and labor hours.

• Total Costs (TC): Sum of fixed and variable costs, representing the entire expense of production.

Economic Insights on Costs

• Average Costs: Understanding average costs can help in pricing strategy and financial assessment.

  • Average Fixed Costs (AFC) = TFC/Q

  • Average Variable Costs (AVC) = TVC/Q

  • Average Total Costs (ATC) = TC/Q

• Marginal Costs (MC): Change in total costs per additional unit produced, playing a significant role in pricing decisions and output levels.

Understanding Marginal Cost Effects

Explanation of how changes in marginal cost impact average total and variable costs is essential for financial predictions and strategy adjustments.

Long Run Production Costs

In the long run, all production costs become variable as firms adjust all inputs, including plant size, in response to demand and market changes. This often results in different short-run ATCs leading to an overall long-run ATC that reflects the firm’s efficiency and scalability.

Long Run Cost Decisions

• The transition from fixed to variable costs occurs as firms grow or adjust their capacities based on forecasted demand changes. For instance, businesses may invest in larger facilities to support anticipated increased production needs.

• Examples of Cost Decisions:

  • Short Run Decisions: Hiring more workers to meet surges in demand without altering fixed assets such as factory size.

  • Long Run Decisions: Expanding a factory when demand necessitates increased production capacity involves significant capital and commitment.

Economies of Scale

• Economies of Scale: Cost advantages gained from increasing production, such as better rates from suppliers and increased efficiency through specialization of labor.

• Diseconomies of Scale: Occur when increased production leads to higher per-unit costs due to complexities in management and decreased employee morale.

Application to Real-World Scenarios

A thorough analysis of current economic scenarios, including rising gasoline prices affecting transportation costs for airlines and construction firms, provides perspective on the dynamic nature of production costs.

Sunk Costs

Definition and Importance: Recognizing sunk costs—costs that cannot be recovered—is crucial in business decision-making. Entrepreneurs should focus on the potential future benefits rather than being influenced by past expenditures to make rational economic choices.